Apollo Investment Management

Limits to growth
Apollo Asia Fund: the manager's report for 1Q2010

The Apollo Asia Fund's NAV rose 7% in the first quarter, to a new high of US$983.02: up 70% over the last twelve months, but only 9% compared to the earlier peak of May 2008. Over that period, we would have done better to sit out the equity markets and own gold bullion. Charts.

During the quarter, portfolio activity was again very limited: we sold the remains of two small positions, lightened three and added to three.

Portfolio earnings performance for 2009 was a little better than we had expected, so despite higher prices the valuations seem superficially a little more reasonable than those cited in the last report. At the end-of March, the historic PE was 14.4, and the current-year forecast 13.9 - still at the high end of the fund's experience, but not wholly unreasonable. (Our earnings figures strip out the valuation gains which now tend to flatter the reported figures and hence market aggregates.)

Geographical breakdown
by listing; 31 Mar 10
% of assets
Hong Kong
Other equities
Net cash & receivables

Our concern is over future earnings, given the precarious state of the global economy and doubtful prospects for Asia's exports. Since none of the major problems exposed by the crisis has been addressed, and panic responses have created new ones, major turbulence seems likely to resume. Many of the stocks in our universe are priced on cheery assumptions of business-as-usual: a less complacent view restricts our choices considerably.

Furthermore, the customary assumptions of long-term trend growth for the world, looking out beyond the business cycles to the next 10-30 years, seem increasingly hard to justify given the growing evidence that we are on this timeframe running up against hard limits to availability of resources. It is ironic that we should reach this point just as the pursuit of GDP has become the consensus goal of governments around the world. Continual GDP growth is an absurd goal, bearing little relationship to quality of life, and treating the consumption of assets as a positive. It may now become an impossible goal, not just because of the looming debt traps, but because GDP growth has historically been accompanied by more and more energy usage, and that may no longer be possible. The ability of oil producers to increase output each year is increasingly in question - and the interest of oil-producing countries in nuclear power suggests that many see their own supply falling short of demand within the next 10-20 years. For a long time, limits to growth were far enough away to be beyond the practical horizon of investment calculations, but that is no longer the case.

Asia, at lower levels of per-capita consumption and less constrained by legacy debt, may well be able to outbid the OECD and continue to increase its share of energy and other resources traded. However, leaving aside the impact on export markets, it may not always be just a matter of price, and it cannot be assumed that Asia will always be able to obtain the absolute quantities of resources to sustain the levels of growth to which it has become accustomed. Moreover, those countries which have been subsidised by windfall resource endowments may face shocks when they become net importers. See our recent overview of energy for Asia.

With many more imminent problems in developed markets, deposit rates miniscule, and bond market risks widely appreciated, Asia however continues to look a relative safe haven - and it has often been more overvalued in the past, so it will doubtless go up until it stops. With no claim to market-timing ability, we are 92% invested at the time of writing.

Our stake in Aero Inventory was written off in November when it went into administration, and it seems most unlikely that there will be any writeback. The administrators' report, dated 4th Jan and for which we had been waiting until I belatedly discovered it posted on the website of Companies House, was shocking reading. Their figure for the recoverable value of inventory, which they consider "challenging", is 43% of book value; and the book value is based on sales price, not on cost or estimated realisable value, "due to issues with the stock system"...! I had always considered this a high-risk investment (and wrongly thought it potentially high-reward), but it had honestly never occurred to me that a company whose whole rationale was the efficient management of inventory, especially with the strong financial credentials of AI's management team and board, did not have an accounting system in place which could, hmm, keep track of the inventory... This sounds much more far-reaching than the earlier indications of a problem with inventory of the Canadian acquisition ACTS. Of all the audit failures I have seen, this seems to have been at the most elementary level. The auditor was Deloitte & Touche. Can any reader enlighten me as to the liability of the auditor and other parties, and the scope for class action, under UK company law?

Returning to a point made in the last report, it would surely be desirable to have a more public post-mortem regarding corporate failures. Perhaps this is in the pipeline, but UK commentators seem to have little confidence that the Serious Fraud Office and other investigating authorities (which presumably include the Financial Reporting Council, 'responsible for promoting confidence in corporate reporting and governance') will ever tell the public what happened. Meanwhile the LSE's only public response was to wash its hands of the company and remove all of its documents from the website, hindering the post-mortems of investors and all those who might wish to learn from the experience. The company's website still exists, but again all documents have been removed by the administrators. Fortunately we had downloaded copies of most, and would be happy to forward copies to anyone interested.

Let's hope that we do at least learn from our own experience, and have few more such casualties in what we expect to be testing times ahead.

Claire Barnes, 5 April 2010

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